The 'January effect' could be the market's big hope for a bounce

Money managers tend to sell losers along with winners to minimize the tax bill from the capital increases.

"Tax loss selling made December much sloppier than it otherwise might have been," says Nicholas Colas, co-founder of DataTrek Research.

Traders work on the floor of the New York Stock Exchange.

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Despite Wednesday's record-breaking rally, the Dow and S&P 500 are still on track for their worst December since the Great Depression. While much of the blame has been cast on the Federal Reserve, President Donald Trump's tweets and the trade war, one overlooked explanation for the bleeding is tax selling.

Although the year-end tax selling intensified December's stock rout, it will likely yield to a bounce in January, which is the logic behind Wall Street's "January effect," a theory that there is a seasonal rally in stocks during the first month of the year, according to Nicholas Colas,co-founder of DataTrek Research.

"The idea is that beaten up small cap stocks tend to trade higher in January as tax loss selling abates and more normal buy-sell balances reassert themselves," Colas said in a note to investors.

When money managers get hit by a sharp reversal in stock prices, not only do they sell the winners from early in the year to reap the gains, they also tend to sell some losers to minimize the tax bill from the capital increases — the so-called tax selling, which is very much at play in December, according to Colas.

Shares of the 11 companies lost 21.1 percent on average from the last day of November to Dec. 24, while the S&P 500 and Russell 2000 bled 14.8 percent and 17.4 percent, respectively. However, 10 of the 11 names turned around on Wednesday, outperforming the S&P 500 and posting an average gain of 6.8 percent.

"With tax loss selling likely near the tail end or done, this makes sense," Colas said in a note to investors. "Tax loss selling made December much sloppier than it otherwise might have been. It depressed many stocks that were already on track for sizeable losses. And it made the lives of active mutual fund managers very difficult as they sold holdings to keep up with redemptions."

January also features one of Wall Street's favorite seasonal gauges — the January barometer. History has shown that since 1950 every down January for the S&P 500 preceded a new or extended bear market, a flat market, or at least a 10 percent correction. So if January turns out to be positive, the historically accurate January barometer could rescue stocks from a bear market.